This is Part 1 of a guest contribution by David Kotok* and Bob Eisenbeis** of Cumberland Advisors. (Part 2 follows tomorrow.)

Note to Readers:  This is the first of a two-part commentary motivated by speeches and editorials from Federal Reserve officials about possible exit strategies from its current quantitative easing policies.  We comment on some problems that the strategies may pose.  We also identify subsidies in the Fed’s current policies.  In part two we comment on the Fed’s own operating policies that may have played an important role in creating the too-big-to-fail problem.  This last issue was overlooked by the Dallas Fed’s Fisher and Rosenblum in their WSJ op-ed piece of September 27, 2009.  They lamented the bottleneck that the concentration of banking resources now creates as the Fed attempts to exit its QE strategy.  They fail to mention how the Fed’s determination of primary-dealer status has contributed to the problem

It is becoming increasingly clear from recent information coming from the Fed that its exit strategy from the crisis-induced injection of liquidity will rely upon two mechanisms.  First, the Fed will try to sop up excess reserves by engaging in reverse repurchase (RP) agreements using accumulated mortgage and Treasury debt.  Second, the Fed will attempt to adjust interest rates upward and perhaps sharply, as Governor Warsh recently suggested.

The Fed will attempt to sterilize the excess reserves that it has created and that have accumulated by raising the interest rate it pays on such funds that are placed with the Fed by banks.  The Fed could also raise reserve requirements, although there is no indication they will pursue the reserve requirement course.

If the Fed follows the mechanism that is now used by many other central banks, the rate paid on excess reserves will set a floor, the discount rate will set a ceiling, and the targeted Federal Funds (FF) rate will be in the middle.  The actual transaction-driven effective FF rate will fluctuate within that floor-ceiling corridor.  At least that is the theoretical construction.

Presently, an apparent anomaly exists in the FF market.  The interest rate the Fed is paying on excess reserves is 25 basis points, the desired target for the FF rate is defined to be a range of between 0 and 25 basis points (less than or equal to the excess reserve rate), and the discount rate is set at 50 basis points.  The effective FF rate is trading roughly in the range of 14 to 16 basis points.  The 25 basis points the Fed is paying on excess reserves, while consistent with the target, sets up a riskless arbitrage possibility for banks.  They can borrow at 14-16 basis points in the FF market and immediately lend to the Fed at 25 basis points – they make 9-11 basis points risk-free.

Part of the reason the effective FF rate is below the upper range of the target is explained by the actions of Freddie and Fannie, who accumulate large volumes of cash payments from mortgages until required disbursements are made on mortgage-backed securities and they must deploy those funds on a short-term basis.  The GSEs can’t hold deposits at the Fed or earn the interest on excess reserves that the banks are able to earn.

Because GSEs are not banks, they are faced with either earning a zero return on those funds by simply sitting on idle balances or they can lend the funds in the FF market, which they are doing at rates below what the Fed is paying on excess reserves.  This arbitrage is a direct subsidy from the government (Freddie and Fannie are now under government conservatorship) and from the Federal Reserve to the banks, because it enables them to improve earnings and build their capital.

As long as the Fed wants to subsidize the banks, it will be difficult for it to raise interest rates with the FF rate trading below the rate paid on reserves.  This pattern is particularly likely as long as Freddie and Fannie continue to pump funds into the market.

Click here for the full article.

Source: Bob Eisenbeis and David Kotok, Cumberland Advisors, October 2, 2009.

* David Kotok is the Chairman and Chief Investment Officer of Cumberland Advisors. He cofounded the firm in 1973 and has guided its investment strategy from inception. Mr. Kotok holds a B.S. degree in economics from the Wharton School as well as dual master’s degrees from the University of Pennsylvania.

** Dr. Robert Eisenbeis has joined Cumberland Advisors as Chief Monetary Economist. In that capacity, he will advise Cumberland’s asset managers on developments in US financial markets and the domestic economy and their implications for investment and trading strategies.

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